Over a decade ago, Vanguard coined the term “advisor’s alpha” as a measure of the value added by passive advisors who adhere to the principles of controlling costs, maintaining discipline and tax awareness. More recently, Vanguard quantified the value of advisor alpha at 3%, basing their number on the sum of estimated values of cost savings from using low-cost funds, disciplined rebalancing, behavioral coaching and asset location/withdrawal strategies.1

Advisors who play an active role in emotions management can be referred to as “passive advisors.” These knowledgeable advisors help maximize investor success by providing the critical discipline required to combat emotional reactions like pulling out of the market the way so many did in the downturn that occurred in 2008 to early 2009. Passive advisors not only help to manage investors’ emotions, they are fiduciary stewards of their clients’ wealth.

Figure 1-6 is a compilation of 20 data points from 15 similar studies that sought to determine the success of the average investor at capturing mutual fund or benchmark portfolio returns. The studies include investors who were following or not following the advice of a passive advisor. Since they leave intuition and forecasting out of their decision making process, passive advisors are also referred to as evidence-based advisors.

Within Figure 1-6, the blue bars indicate that the average mutual fund investor, without the advice of a passive advisor, captured only an average of 50% of fund returns. The purple bars represent investors who invested in index funds, but did not follow the advice of a passive advisor. On average, they captured 80% of the returns of various index funds. Possible explanations might include the failure to rebalance asset allocations during market turbulence, the delay of investing when cash is available, the inability to stay invested during rocky markets, or the failure to heed the ongoing advice of their passive advisor.

The green bars reveal the results of two time periods that looked at the success of index fund investors who have been identified as following the advice of their passive advisors. One study was conducted by my own firm, IFA, and the other by Morningstar in the 2005 Morningstar Indexes Yearbook. These two data points show that individuals who invested in Dimensional Fund Advisors’ funds and used passive advisors captured, on average, all of the fund returns and even a bit more — 105% of the fund returns.3

Don Phillips was the Managing Director of Morningstar when that report was issued. He summarized his findings this way: “Consider the success Dimensional Fund Advisors has had in selling its funds through advisors who undergo training on the merits of passive investing and in portfolio construction theory. Consider that over the past decade the dollar-weighted return of all index funds was just 82% of the time-weighted return investors could have gotten with those funds. Yet, the figures for Dimensional are much better. In fact, the dollar-weighted returns of Dimensional funds over the past 10 years are actually higher than their time-weighted returns, suggesting advisors who use Dimensional encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors.”4 The findings of the Morningstar report are shown in Figure 1-7.

Figure 1-7

Knowledgeable passive advisors help their clients stay invested and rebalance throughout market turbulence. Such behavior enables these investors to maximize their ability to capture returns and provides justification for the right advisor. Many investors are lured into do-it-yourself indexing through index funds and exchange-traded funds (ETFs). This is a step in the right direction, but without an advisor, I would estimate that those investors have not experienced the full value of passive indexing. Quality passive advisors offer valuable services, such as rebalancing, tax loss harvesting, a glide path strategy, and other wealth management tools that, in my experience, are rarely properly applied by do-it-yourself investors. Step 12 provides more information on these topics.

-3 The 109% figure that was calculated in the Morningstar study occurred during a period when there was a high benefit to rebalancing. The 109% applied to individual mutual funds only and would not be applicable to the return shown for a portfolio of mutual funds across different asset classes.

The data provided in all charts referring to IFA Index Portfolios is hypothetical backtested performance and is not actual client performance. Only data for the IFA Index Portfolios is shown net of IFA's highest advisory fee and the underlying mutual fund expenses. All other data, including the IFA Indexes, does not reflect a deduction of advisory fees. None of the data reflects trading costs or taxes, which would have lowered performance by these costs. See more important disclosures at ifabt.com.